Streetwise

Lauren Rudd

Sunday, July 21, 2013

Anyone Can Slice and Dice Data

It is not unusual for various prognosticators to promulgate the supposition that Wall Street's volatility and resultant risks are likely to outweigh any possible returns. Such comments are not only misleading, they are dubious at best and at worst they are simply wrong. Of course, with a little ingenuity you can always postulate a set of circumstances where investing in equities is an inappropriate strategy.

For example, a carefully selected time series of market data is often utilized to validate a hypothesis, either pro or con, in an effort to encourage or discourage you from undertaking a particular investment program.

Be careful, anyone can slice and dice historical data in such a way as to segregate out those periods when the stock market did very well. And it is just as easy to find periods when the stock market did not do well. The funny thing is that market statistics of that nature will have little or no bearing on your portfolio’s performance.

During a bull market when it seems every stock is advancing, it is not unusual for investors to chalk up negative returns. Likewise, positive returns can be achieved when the markets have a glide path similar to your average brick. Having analyzed countless portfolios over the years, I can personally attest to the validity of those statements.

Over time a stock gains in value because the underlying company reinvests some or all of its earnings back into the business, thereby creating a compounding effect and subsequently an increase the value of the company and its shares.

As Benjamin Graham, the father of investment analysis, so carefully pointed out, your investment strategy should be to select only quality companies in which you can become a partner at a discounted price. In other words, do not invest in the market; invest in the future of a specific company.

Nonetheless, investors are continually encouraged to move in and out of the market or in and out of specific stocks, all in the name of rebalancing, and with the encouragement of so-called "experts" and their sanguine analysis.

That so-called analysis amounts to nothing more than pernicious, albeit influential, nonsense. As Peter Lynch, former manager of the Fidelity Magellan Fund, said, "Far more money has been lost by investors preparing for corrections than has been lost in the corrections themselves."

But why should there be volatility in the first place? According to British economist Paul Ormerod, "We need to look to the influence that market players have on each other, which in turn triggers unstable systems of immense complexity."

In his book "Butterfly Economics," Ormerod contends that we can find the answers in chaos theory. Developed in the 1960s by meteorologist Edward Lorenz, chaos theory puts forth the idea that small events can have unexpectedly large effects.

One example given by Ormerod is Thailand's devaluation, the effects of which spread like the ripples across a pond. In that instance, first Thailand's Asian neighbors, then Russia and finally Latin America were all sucked into a maelstrom no one could have predicted when the lowly Thai baht was floated in July 1997.

I would offer up a more current example. A few words by Federal Reserve Chairman Ben Bernanke or one of his esteemed colleagues, and the ensuing market volatility is hauntingly similar to mass hysteria.

Graham tackled the volatility question in his classic book Security Analysis. Keep in mind that “Security Analysis” was first published in 1934, a time when the public faith in the stock market had all but totally collapsed.

Graham believed that "the processes of the stock market are psychological more than arithmetical." This meant that the impact of market psychology ensured that stocks would either be undervalued or overvalued. Furthermore, according to Graham it was possible to distinguish between the two in rational manner.